Mutual Funds Report; This Manager Keeps His Focus on the Balance Sheet

ROBERT A. OLSTEIN says he was not surprised by the recent wave of corporate accounting scandals. For nearly his entire Wall Street career, Mr. Olstein has been watchful about accounting irregularities.

''It ebbs and flows, and in a bull market, as valuations grow, so do imaginations and creativity,'' said Mr. Olstein, 61, who runs the $1.4 billion Olstein Financial Alert fund, based in Purchase, N.Y.

For more than three decades, Mr. Olstein has spoken out about financial flaws in companies' books. From 1998 to 2002, he said, such scrutiny helped his mutual fund dodge problems he saw in the financial statements of Lucent Technologies, Sunbeam and General Electric. He said he had successfully shorted all of these stocks -- selling borrowed shares, which he later bought at a lower price.

The fund has gained 2.9 percent a year, on average, in the three years through June, outperforming its peer group of midcap blend funds, which lost 1 percent, according to Morningstar Inc. The Standard & Poor's 500-stock index lost 11.2 percent. Over the last five years, the fund gained 11.2 percent, annualized, versus a gain of 4 percent for its group and a loss of 1.5 percent for the index.

The strategy's benefits are twofold, he said. Scrutinizing financial statements helps him avoid companies that could implode. And knowing that balance sheets are strong gives him confidence to invest in a flagging company or an industry that he thinks will rebound. In those cases, he will take an operating risk, but not a financial risk.

''If I'm predicting the operations will turn around, I have time for that to happen rather than a ticking time bomb,'' he said.

Time does not always help, however. In the summer of 2002, Mr. Olstein bought a number of semiconductor stocks because of his view that their low valuations, relatively sound balance sheets and potentially heightened demand could lift prices over time. The better capitalized contenders bought by Mr. Olstein included LSI Logic, National Semiconductor, TriQuint Semiconductor and International Rectifier. But he said he realized later that he was overly optimistic about how much cash flow they would generate, and began selling. He estimates that this misjudgment cost his fund about two percentage points in 2002. That year, the fund lost 19.3 percent, about 2.6 points behind its peer group, according to Morningstar.

''One of the hardest things to do is sell a mistake,'' he said. ''But you buy conservative balance sheets because it gives you a floor to liquidate your positions.''

Buying companies at attractive valuations, then waiting for their rebound is the core of his approach. He and his six-member team seek companies with strong cash flow and try to buy them at a discount.

In waiting for an investment to pay off, Mr. Olstein says, he tries to be patient. For the 12 months through June, the fund has gained 6.2 percent, much of it from financial services and insurance stocks bought last fall. Those include Chubb and Everest Re, as well as Merrill Lynch, Goldman Sachs and Neuberger Berman.

The health care industry attracts him these days. He recently bought small positions in Tenet Healthcare and United Health Services.

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The fund has an expense ratio of 2.17 percent, versus an average of 1.46 percent for similar funds, according to Morningstar. The expenses are high in part because they include a 1 percent distribution fee, which gives brokers an incentive to sell the fund.

Mr. Olstein is so focused on balance sheet analysis that he refuses to meet with company management for fear of being influenced.

During his first years on Wall Street, in 1968 and 1969, he worked as an analyst for a small brokerage firm, Scheinman, Hochstin & Trotta, which is no longer in business, and covered Varo, a night-vision-equipment company, which is no longer publicly traded. He said he believed Varo management's bullish talk about the company and recommended the stock. The company failed to meet its earnings targets, and the stock plummeted.

''I hung out with them too much, and I lost a lot of money for people,'' Mr. Olstein said.

His newfound skepticism took root in the Quality of Earnings Report, a newsletter he founded with Thornton O'Glove, another analyst, in 1970. The newsletter scrutinized company balance sheets and often warned subscribers about problems.

''He was one of the first to really look at corporate accounting, and he had a very, very well-recognized newsletter,'' said David Dreman, chairman of Dreman Value Advisors.

Investing based on his type of balance-sheet scrutiny was a natural step for Mr. Olstein. He managed private accounts for Salomon Smith Barney from 1981 to 1995, and started his own mutual fund in 1995.

He says he maintains his vigilance in scrutinizing balance sheets, but he has not identified any major red flags lately. After years of chiding analysts for being ''pompom boys,'' he now says he believes the pendulum has swung too far in the other direction and that analysts have become too negative. He says he is closely watching eBay and Amazon.com, only because he considers their prices very high relative to their cash flow, and because companies in similar situations have been tempted to alter their financial statements to justify overvaluation by the market.

''Sometimes when valuations get up, people sometimes get creative,'' he said, adding that he had found nothing amiss at those two companies.

His latest project is agitating for tort reform. Mr. Olstein, a prolific correspondent, has been writing letters to Maurice R. Greenberg, chief executive of the American International Group, the insurer, who has criticized the size of recent jury awards and has called for state and federal legislation to address it. Mr. Olstein said he would like to eliminate class-action lawsuits entirely.

''The congressmen and attorneys general should be going after the trial attorneys who are wiping out over $300 billion from the economic system and they're preying on the small investors,'' Mr. Olstein said. ''I'm just revving up -- if I think something's unfair, I go after it.''

Correction: July 13, 2003, Sunday An article last Sunday in the Mutual Funds Report, Part 2 of this section, about Robert A. Olstein, manager of the Olstein Financial Alert fund, misstated the name of a company held in the fund's portfolio. It is Universal Health Services, not United Health Services.